Chart Patterns

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Chart patterns are a series of graphed stock prices forming recognizable
patterns that can be used to forecast future stock prices.
There are many well-known chart patterns, which are formations
that technical analysts use to forecast the direction of future stock
prices. Many technical analysts believe that by plotting prices over
a period, they can predict how long a stock will advance or decline,
as well as identify its support and resistance levels. After analysts
choose the type of chart, they look for emerging price formations.
See Figure 11–5 for a few examples of common formations. From
volume and price chart patterns, trend lines, and support and
resistance levels, technical analysts believe that they can predict the
appropriate price at which to buy or sell a stock.

Interpreting the types of patterns can be difficult for beginning
chartists. First, you have the nonemergence of common patterns
(such as the example in Figure 11–5). Second, the buy and sell signals
may not be obvious to the reader of the chart. Third, a technical
analyst doesn’t care whether a double-bottom formation chart
belongs to Intel Corporation or a speculative company—the double
bottom means the same for Intel and the speculative company, and
their future stock prices are expected to perform in the same way.
This statement implies that stock picking is a simplistic exercise that
does not require any financial expertise other than obtaining price
and volume information on stocks and the market.

Figure 11-5
Chart Patterns

A trend consists of relatively constant price movements of a
security or market over time. Technical analysts plot their charts
and then look for trends in their charts. A trend is the direction of
the movement of the price of a stock or the market. The direction
could be upward, downward, or sideways. Prices generally move
in a jagged pattern. A succession of high and low points higher
than the previous data signifies an upward trend. The opposite is
true of a downward trend. These upward or downward trends are
illustrated in Figure 11–6. Investors who follow technical analysis
presume that the momentum in the markets will continue to
perpetuate these trends.

Figure 11-6
Trend Lines

A resistance level is the price at which a security or market
encounters considerable selling pressure. During an upward or
sideways trend, a pricing point to which the stock rises and then
repeatedly falls below without breaking through is called a resistance
level (see Figure 11–7). At this level of resistance, when the
stock reaches the high side of its trading range, investors sell the
stock in order to take profits. These sales prevent the stock from
moving higher and breaking out of the resistance level.

Asupport level is the price at which a security or market encounters
considerable buying pressure. Similarly, during a downward or
sideways trend, a lower level of trading, called a support level might
occur. At this level, the stock price bottoms out before increasing
because investors are buying the stock. This concept also is illustrated
in Figure 11–7, where the stock rises to around $30 per share
only to fall back each time.

A breakout occurs when the price of a security or market
moves above a resistance level or below a support level. Finally, the
stock in Figure 11–7 surprises technical analysts by rising above the
$30 level. For technical analysts, a breakout below a support level or
above a resistance level is significant. Technical analysts believe
that when stocks break out of their support or resistance levels, the
stock prices will continue to move lower or higher, respectively,
which establishes new levels of support or resistance. The analysts’
explanations for this momentum appear to be twofold. When
investors see that the price breaks through the resistance level,
they will want to own this stock, which perpetuates additional
enthusiastic buying of this stock. Second, some positive fundamental
information might have accounted for the breakout, and
when the public hears about this information, the stock price has
already reacted. At that point, small investors jump on the bandwagon
to buy. The opposite is true for breakouts in the support
level, where selling momentum pushes the stock lower.

Figure 11-7
Line Chart Showing Support and Resistance Levels

Technical analysts are not that concerned about fundamental
information but rather about identifying trading patterns as a consequence
of reactions to the release of information. Charting is
much easier than fundamental analysis, and stock price information
is easy to get at virtually no cost. However, the value of charting
as a method for predicting future stock prices and profits has
been questioned often by fundamental analysts and academicians.
Table 11–2 discusses the views of fundamental versus technical
analysts.

Many chartists attribute their successes to their charts, but the
crux of the matter—when to buy and sell—may lie more in the
chartist’s judgment than in the charts themselves. If charting were
that simple, investors all would have the stock market sewn up by
now, and we could be sitting on the beaches of the French Riviera!
Many free sources on the Internet make charting information
available, such as www.askresearch.com, www.stockcharts.com, and
www.siliconinvestor.com. For the stocks of your choice, you can
obtain line, bar, or candlestick charts along with moving-average
trend lines.

Table 11-2
Should You Use Charts or Fundamentals to Choose Stocks

Technical analysis and fundamental analysis presented quite a different view of defense
industry stocks. From a technical point of view, the prices of most of the defense stocks
had fallen below their support levels, which indicated future negative trends. In contrast,
the fundamentals for these stocks looked quite good, in that during the war with Iraq,
the U.S. government would need to procure more weapons and develop new weapons
systems. Figure 11–8 illustrates a five-year price chart of Boeing’s stock price that
shows the breakdown of Boeing’s stock price below its support level. The chart pattern
is a classic head and shoulders pattern (Zawadzinski-Edwards, 2003, p. 20).

Yola Zawadzinski-Edwards, an independent technical analyst, said that the drop in Boeing’s
stock, having broken down to $26.52, below the neckline, indicated that the stock would
continue to fall toward 0 over the following 10 months. The head and shoulders pattern is
indicative of a bearish outlook, especially when the stock price continues on a downward
trend from the right shoulder. The other negative from a technical point of view is that the
stock price had fallen below the support level of around $19 to $25 per share.

Figure 11-8
Five-Year Stock Price Chart of Boeing

However, fundamental analysts were more bullish on Boeing’s prospects. The threat of
future terrorist incidents and the war in Iraq caused a drop in airline traffic that resulted
in declining orders for airplanes from Boeing. However, the flip side of the coin is that
only two major commercial airplane manufacturers exist: Boeing and Airbus. When
world events settled down, Boeing would see its commercial aircraft business return
to normal levels. Boeing’s military business held the company’s sales and earnings
together. In fact, Boeing’s low stock price was based on the valuation of the military
business, whereas the commercial aircraft unit had no value. Consequently, an improvement
in the commercial aircraft business caused Boeing’s stock to rise significantly
in the following years.